MD140

TO MANAGING DIRECTORS OF ALL

WATER AND SEWERAGE COMPANIES

AND WATER ONLY COMPANIES

8 October 1998

THE TREATMENT OF MERGER SAVINGS AT THE PERIODIC REVIEW

In MD136, I invited your views on proposals for the treatment of merger efficiency savings at the forthcoming Review. Responses were invited by 31 July 1998. I received eighteen responses, which we have considered carefully. I am now writing to inform you how I will be treating merger efficiency savings at the Periodic Review.

Mergers – implications for all companies

The majority of companies did not consider it inappropriate that, in setting both industry-wide and company specific efficiency targets, I should take into account economies of scale and synergy savings that multi-utilities may have achieved.

I therefore intend - as originally proposed - to take into account synergy savings available from companies combining activities when setting price limits.

Water-water mergers – implications for merged companies

For mergers between two water (and sewerage) undertakers, price cuts have generally formed part of a package of measures designed to ameliorate the loss of a comparator to the regulatory regime. MD136 proposed that for such a company which has become a leading comparator, price limits will be set as for other companies, but for such companies which have not achieved leading comparator status, the pressure created by the agreed merger price cut should survive the Review.

There were no strong objections to these proposals. A number of companies did, however, consider that a rigid, leading comparator assessment was inappropriate and that companies should be judged on whether or not they have achieved the agreed package of measures. I agree with this distinction and propose to adjust my approach. I will judge a merged company on whether it has achieved the agreed package of measures, not whether it has achieved leading comparator status.

At the 1999 Periodic Review, for companies which, following such a merger, have achieved the agreed package of measures, price limits will be set as for other companies. No further action is needed, since the merger price cuts will have delivered what was intended.

For those companies that have not achieved the agreed package of measures by the time of the Review, it will be necessary to ensure that the particular pressure created by them survives the Review. If necessary, I will adjust the costs of such companies as set out in MD136.

Other mergers – implications for merged companies

In MD136, I asked for your views on the treatment of merger savings in a company which has merged with a non-water company. Specifically, I asked whether such a company which has also become a leading comparator should retain some additional benefit over the second best comparator.

In response, one company suggested merger savings should be retained even if the company has not achieved leading comparator status. However, the majority of responses stressed that the proposal in MD136 would give preferential treatment to merged companies, as the additional benefit would not apply to any company that achieved leading comparator status.

To ensure that all companies are treated consistently, I agree that to allow a merged company to retain some additional benefit would give undue preference to those companies which have chosen a particular means of corporate development, namely multi-utility mergers. To introduce such distortions to the market would be inappropriate. I therefore propose to change my position in light of the consultation and, at the Periodic Review, I will not be treating such merged water-non-water companies differently from other companies that have achieved leading comparator status.

I C R BYATT